Tags: China | Bond | Default

Investors Brace for China's First Bond Default

Thursday, 29 March 2012 01:37 PM

China's fledgling corporate debt market will face a watershed moment next month, when an insolvent manufacturer of chemical fibers may become the first company in the brief history of the country's bond market to default on its obligations.

A default by Shandong Helon, which has 400 million yuan ($63.43 million) in commercial paper maturing on April 15, would send shockwaves through China's bond market, pushing up yields on lower-rated corporate paper, analysts say.

But in the long run, many market participants believe a default would aid the development of China's bond market, where investors today widely assume that the government will always step in with a bailout.

Default would force investors to start taking credit risk seriously.

"Hopefully it will be a wake-up call to investors as to how they are pricing risk, because before they weren't pricing risk," said Fraser Howie, chief executive of brokerage CLSA in Singapore and co-author of a book on China's financial system, "Red Capitalism".

A Chinese bond trader at a foreign bank in Shanghai agreed. "We don't really have a credit risk culture," he said. Ultimately, better risk pricing should improve the market's ability to deliver credit to smaller, riskier, privately-owned firms who currently struggle to access credit in China's bank-dominated financial system. In the short term, however, a default would bring pain to China's small- and medium-sized enterprises, especially private companies. Such firms have increasingly turned to the bond market as bank loans have become scarcer due to a combination of tighter monetary policy and risk aversion by banks.

"Spreads of the AA- and below sectors may widen out if Helon defaults, as markets may believe other sectors are subject to similar default as well," said Zhang Zhiming, head of China research for HSBC in Hong Kong. "The entire sector might be shut down temporarily," he said.

Foreign Impact

Foreign participation in China's domestic bond market is limited due to China's closed capital account, though Beijing has been accelerating its approval process to allow more capital inflows into its stock and bond markets.

At least 33 Hong Kong banks - including subsidiaries of both foreign and Chinese banks - have obtained quotas that allow them to reinvest offshore yuan deposits in China's onshore interbank market, where 97 percent of Chinese bonds are traded.

Banks that have accumulated offshore yuan deposits through participation in China's cross-border yuan trade settlement program, launched in 2009, may apply to the People's Bank of China for a quota. But those quotes likely account for only a tiny portion of the market. The impact of Helon default on sentiment towards Chinese offshore bonds would likely be limited.

Offshore issuance of dollar-denominated bonds by Chinese companies exploded in 2010-11, but analysts say that current yields already reflect concerns about corporate governance, and the limited ability of offshore investors to access onshore assets in the event of default are already priced in.

"Generally, the dollar space - whether it's in the China property space or the industrial space - there is an excess premium over general high-yield names to reflect the issues," said Dilip Shahani, Asia Pacific head of global research at HSBC in Hong Kong.

One Thing After Another

Everything seemed fine when Shenzhen-listed Helon, based in the east coast city of Weifang, issued 400 million yuan in short-term commercial paper in April 2011.

The bonds, which carried a 5.8 percent coupon, were rated A-1 by China Lianhe Credit Rating Co., Ltd., a major domestic agency, while the company itself was rated A+. Though the rating was low by the standards of China's bond market, where 80 percent of issues are rated AA or above, according to HSBC, investors likely took comfort from the Weifang city government's 16 percent stake in the company. But a series of damaging disclosures soon revealed the company's disastrous financial condition.

In September, the stock exchange reprimanded Helon after a probe by the securities regulator revealed 523 million yuan ($83 million) in irregular guarantees by Helon to its subsidiaries, more than 50 percent of its net assets, that the company had not disclosed.

Bleaker news followed in December, when Helon announced adjustments to its financial statements from 2008 to 2011, showing combined losses of 1.37 billion yuan ($217 million) from 2008 through the third quarter of 2011, twice as much as previously reported.

Shareholder's equity was revised down to negative 246 million yuan ($39 million) from 516 million yuan ($81.8 million). As of March 23, the company had overdue loans totaling 879 million yuan ($139.3 million), equal to 557 percent of net assets.

After a series of downgrades, the company's paper, which matures on April 15, is rated C, and the company's long-term rating is CCC. The bonds currently yield 77.8 percent. Meanwhile, a slew of top executives departed the company, whose stock had been suspended in August.

Deus Ex Bailout?

It is clear that Helon will be unable to repay its bonds without outside help. The eyes of the market are now on the Weifang government, which may still step in with a rescue.

HSBC's Zhang says that if a similar situation had arisen last year, officials would have been more willing to enforce market discipline by letting the company default.

But with the Chinese economy slowing and a once-in-a-decade leadership transition scheduled for late this year, officials prefer a short-term fix to a loss of market confidence that could weaken the flow of credit to the economy.

"This is a sensitive year, and already local officials are saying, 'Don't worry, restructuring is underway. Bond-holders will get paid.' So perhaps the odds are in favor of a last-minute bailout," said Zhang. Another possibility is that the company will receive an indirect bailout, with the local government using its influence to persuade banks to provide more loans.

In mid-March, the company announced that it had applied to nine separate banks, including all of the "big four" state-owned banks, for a combined 900 million yuan in new loans and credit lines, with its subsidiaries offering guarantees. All the applications were made to bank branches located in or around Weifang.

A default by Helon would also serve as an important test of China's legal system to protect the rights of bond-holders and facilitate asset recovery. Several of Helon's creditor banks, including China Everbright Bank, China Merchants Bank, and Shenzhen Development Bank, have already sued the company for repayment of outstanding loans, but no judgments have been issued.

© 2018 Thomson/Reuters. All rights reserved.

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Thursday, 29 March 2012 01:37 PM
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